SAFT ON WEALTH: Rethinking the 4 percent rule

Feb 7 (Reuters) – In a world of low structural investment
returns retirees need to reconsider the assumption that they can
draw down 4 percent a year of their savings.

Known as the 4 percent rule, this popular guideline is
running smack into what looks to be an extended period of low
returns in stocks and bonds.

Obviously, this is important not just for retirees, who may
have little choice but to cut back on consumption, but for
savers too, who will need to save more or work longer to safely
meet their targets. It equally applies to foundations and
endowments, which struggle with how much they can fund and still
keep contributing in perpetuity.

For all investors, a low-return world is one in which high
fees are especially damaging.

Popularized by financial advisor William Bengen, who did the
original research behind the idea in the 1990s, the 4 percent
rule holds that an investor who wants her retirement assets to
last for 30 years should draw down 4 percent of the principal in
the first year, increasing drawdowns annually by inflation.

Bengen found that those who drew down 5 percent a year on a
simple portfolio of S&P 500 stocks and Treasury bonds
had a 30 percent chance of their assets being
exhausted before their target date. Later research, using a more
diversified portfolio, ratcheted drawdowns up to 4.5 percent.
However, these assumptions were based on historical equity
returns which outpaced inflation by 6 percent or more and,
which, simply put, may not be repeated.

Now, there are a fair number of problems with the 4 percent
rule; some good, like increasing longevity, and some bad. Among
the worst is that the rule, and its acceptance, is running afoul
of the low-return world in which we now live, and which may
continue for a good part of the next 30 years.

Credit Suisse released this week its Global Investment
Returns Yearbook for 2013, which included a study by Elroy
Dimson, Paul Marsh and Mike Staunton of the London Business
School on the dynamics and implications of a low-return world.
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“To maintain the real value of a perpetual endowment, the
withdrawal or spending rate should not exceed the expected real
return on the assets. We have estimated that over the next
20-30 years, global investors, paying low levels of withholding
tax and management fees, can expect to earn an annualized real
return of no more than 3 percent on an all-equity fund and 2
percent on a fund split equally between equities and government
bonds,” the authors write. “These figures sit uneasily with a 4
percent rule.”

SHRINKING RETURNS

That rather bleak outlook is a huge contrast from the last
60 years. Since 1950, global investors have earned north of 6
percent above inflation annually on both their stock and bond
investments. It is unlikely we’ll see those sorts of returns
over that extended a period for a very long time.

At the heart of this is low interest rates. Real interest
rates – yields minus inflation – are now in negative territory
in most major markets. That’s a bad sign for bonds because not
only is the value of the investment diminishing in purchasing
power terms, risks are also lopsided to the downside. Real rates
could theoretically go lower, but there is a lot more room for
higher inflation, which will cut the capital value of bonds.

The study estimates that real interest rates may not turn
positive for six to eight years, meaning many investors are
looking at negative real returns on bonds and cash over an
extended period.

This also isn’t a great environment for stocks; the lower
real interest rates are historically, the lower equity returns
are in the five years that follow. With low rates here for
several more years, the authors are estimating equity returns to
be just 3 to 3.5 percent above inflation over the next 20 to 30
years. That compares to a 6 percent-plus real return since 1950,
even including the last decade of lost returns.

For those in retirement or close, the upshot, sadly, is that
you probably need to trim expectations and expenditures, or
extend your working life. For those of us still in the asset
building stages of life, the simple reaction is to save more and
not make any early retirement plans.

For all groups, it is time to take a very close look at what
you pay for investment management services. Paying out 1.5 or 2
percent a year is a lot easier to tolerate when you are clearing
6 percent annually above inflation. Paying that amount over the
next 30 years might easily mean giving up 30 percent or more of
your gain annually for investment services.

That’s crippling, especially on a compound basis.

Investors – and wealth managers – who figure this out
quickly will enjoy the most long-term success.